Investing in promise: why are start-ups booming?

In the age of apps, every bright young mind seems to have a million dollar idea. Not all of them are, of course. It’s not difficult to explain the exponential rise in tech start-ups. With a quarter of the world expected to own a smartphone by 2016, any good idea for an app is a potential gold mine.

In the age of apps, every bright young mind seems to have a million dollar idea. Not all of them are, of course.

Not long ago, you may have read about an app that lets you rate other human beings. A ‘Yelp for people’, what could go wrong?

There’s an app that tells you when you’re going to get married based on the age your friends tied the knot.

Another one, the incest prevention alarm, even warns you when you’re about to sleep with your cousin. Now that’s a niche market (I hope).

It’s not difficult to explain the exponential rise in tech start-ups. With a quarter of the world expected to own a smartphone by 2016, any good idea for an app is a potential gold mine.

But there’s another reason. An incredible amount of money is currently being invested in start-ups. So much cash, in fact, that there’s now talk of a start-up bubble.

Who’s for a game of Start-Up Poker?

Start-ups are traditionally a tricky investment choice. You’re investing in potential. They could make a lot of money one day, but they haven’t proved themselves yet.

To some people it simply boils down to a gamble. But then again, some consider a game of poker gambling and some don’t. It probably depends on whether or not you have a seat at the table.

The people investing in these start-ups are called venture capitalists, or VCs. They seed companies in which they see potential in exchange for partial ownership.

You could compare VCs to big record labels signing a lot of promising artists. On most of these acts, the label will make a loss since they never get to have their big break. But if just one lives up to expectations, it makes up for the losses and lets the label walk away with a healthy profit.

Sean explained the way VCs work in more detail in a previous article.

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So why are people going big on start-ups nowadays?

One reason is the sheer volume of them. More money is being invested in apps, because, well, there are so many of them. In April 2009, the Apple App Store counted 35,000 apps; in June of this year, that number had grown to 1.5 million.

Anyone can offer their products and services online now that websites don’t cost much anymore. And apps can be made for less than £6,500. The barriers to entry have never been lower.

Another explanation for the rise in venture capital is the economy. The low interest rates we see today encourage investment. And while many assets struggle to produce profit, start-ups stand out as a group that is still lucrative (that is, if you pick the right ones).

Uber, Snapchat, Dropbox, all of them went from a value of zero to billions in the blink of an eye. They’re what VCs call ‘unicorns’: start-ups with a value that exceeds a billion dollars. Who wouldn’t want a piece of that?

Of course, not every start-up can be a unicorn and this is the danger. Many start-ups may not be worth all that money they receive. This is why people have started to raise concern over a possible bubble.

Indeed, Ben already observed parallels between the rise in start-ups and the dot-com bubble in January.

From my little pony to unicorn to unicorpse?

As I said, there are a lot of investments in start-ups these days. In the past two years alone the number of unicorns has risen dramatically from 39 to 147.

In fact, there are so many potential unicorns at the moment we have seen new terms invented. You now have ‘my little ponies’ ($10 million), ‘centaurs’ ($100 million), ‘decacorns’ ($10 billion) and ‘quinquagintacorns’ ($50 billion).

Perhaps these four names all sound the same to you: bubble, bubble, bubble, bubble.

That may well be the case.

On one hand, the argument against a bubble goes that these start-ups, unlike the dot-com websites, have actual merit. They respond to a need and their innovation has earned them their value.

For a few start-ups, this logic holds true.

But, in many other cases, their value has gone up as a result of investors pushing the price up to make a quick buck. In those instances, the price tag attached to the company no longer represents its actual worth.

That’s when it starts to become a problem.

Like the record label, VCs will eventually want to see returns on their investments. So, what happens when their ‘acts’ are past the talent phase and still haven’t delivered? They will be dumped.

That’s when we get ‘unicorpses’, former unicorns whose value has dropped below $1 billion. If the unicorpses start piling up (and the more unicorns there are the more likely this becomes), then we could see massive losses in this market.

To be fair, many promising start-ups take their time on the private market, resist the urge to take too much money on too soon, and wait until they’re strong enough to go public.

There may or may not be a start-up bubble. But as long as returns on other investments continue to be low, venture capital is likely to keep its attraction. This makes it an interesting area to watch.

Here’s the thing: even if the bubble bursts, VCs know the start-ups with solid ideas will survive. I’ll leave it to you to decide if investing in these companies is a gamble or a skill.

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